Self-employment: How to set up as your own boss

S elf-employment is on the rise. According to the latest official figures, more than 35,000 people joined the ranks of the self-employed during the last year – lifting the total number in the UK now working for themselves to just short of 4 million.

Why this is happening is not hard to answer: redundancies, a lack of good jobs, and the fact that in some industries it can pay to go it alone.

For many, self-employment can be a big and frightening step to take, particularly when it comes to the money side of things.

"For someone becoming self-employed for the first time it can feel as if they are entering uncharted waters alone," says the Federation of Small Businesses. which recently called on the government to do more to promote self-employment. "They will need to work out how they will finance themselves until they secure their first client or contract. They are also legally obliged to register with HM Revenue & Customs (HMRC) within three months of becoming self-employed, or risk a fine."

Your urge to work for yourself might be a response to having been made unemployed, or a lifestyle choice. Perhaps you have come up with a brilliant idea that you think will make you millions. In many professions self-employment or freelancing is, increasingly, the norm. Journalism, certain legal professions, writing and translating, and the arts are all sectors where self-employment is commonplace.

The first thing you need to decide when making the jump from employee to being your own boss is the structure your business will take. There are main options: sole trader, partnership and limited company .

Sole trader This is the simplest way to become self-employed and, as the name suggests, it is for one-man bands. It doesn't involve paying any registration fees, and keeping records and accounts is fairly straightforward – also, you get to keep all the profits. However, you are personally liable for any debts your business runs up, which means it can be a risky option.

Sole traders need to register as self-employed with HMRC and file a self-assessment tax return each year. Any profits are taxed as income, and you pay fixed-rate class 2 national insurance regardless of any profits you make, and class 4 NI on any profits.

Partnership A partnership is a relatively simple and flexible way for two or more people to own and run a business together. Partners are jointly liable for any debts owed by the partnership and so are equally responsible for paying off the whole debt. It's therefore vital to go into partnership with someone you can trust.

"Partnerships will only work if all partners share the same goals and actively work together to achieve them," says Mike Pywell, author of Which? guide Working for Yourself. "As a partnership, the approach and attitude you take to work is much more important than if you are a sole trader."

Limited company Setting up a limited company means you keep your business separate from your personal affairs. It can help to build credibility with other businesses and appear more professional. However, there are a lot more rules to stick to, and paperwork to complete.

Limited companies need to have at least one director and, in some cases, a company secretary. The company must be registered (or incorporated) at Companies House. Limited companies pay corporation tax and submit a company tax return. Companies also need to comply with HMRC's requirements over PAYE for employers and VAT.

Victoria Pooley, founder and managing director of Ipswich-based business The Data Partnership. says: "Limited companies are very easy to set up and are tax-efficient. Had we encountered financial difficulties, the limited liability regulation means our company finances wouldn't impinge on our personal ones.

"Limited companies also offer the directors a very clear shareholding, so directors know what they own. There is a lot of paperwork to set the company up but an accountant does most of this for you."

So what is best?

Tim Gregory, partner at accountants Saffery Champness. says: "A sole trader structure is the simplest. You won't need to register with Companies House, and you won't need to pay corporation tax as well as income tax. If you're not running a payroll, paperwork and red tape will be greatly reduced."

Setting up a limited company takes more time but can save you

money on tax. Most directors take a small salary, then pay themselves (as shareholders) dividends on the profits – and this can have tax advantages.

"Depending on your profits, corporation tax can offer a much more attractive rate than income tax, especially if you want to retain some of the profits in the business for reinvestment," says Gregory.

"Profits left in a company will only suffer corporation tax, but profits taken out are then taxed on the individual as salary or dividends."

However, accounting rules are stricter for limited companies and you will need to produce year-end accounts, including a balance sheet with statutory notes and statements. You will either need to know how to do this or hire an accountant.

"Businesses are so varied that there really is no hard and fast rule for what structure will work, and it is likely that as your business grows and your aims change its structure will need to change too," says Gregory. "A professional adviser can help you choose a structure that fits and offers tax-efficiency."

In some cases it's up to the company concerned to decide whether it wants to register for VAT. But some companies have an obligation to. These include those who provide "taxable supplies" and have a turnover of £73,000 a year or more. If you're VAT-registered, you will have to charge VAT on any goods and services that you provide in the UK that are VAT-taxable. You also have to submit a VAT return to HMRC at regular intervals – usually quarterly.

Help with setting up a company

There's plenty of help and advice for people setting up companies – and it's mostly free.

Government-backed Business Link (businesslink.gov.uk ) advises new businesses on everything from registering a company, tax and employing people, to sales and marketing.

Its website also has a direct link to Companies House. where you can incorporate your new company; to do so, you just need the company's name and registered address, details of the directors and secretary, and information about share capital and shareholders (if any). You also have to pay an £18 registration fee.

If you don't want to do it online, you can complete paper forms and send them off. Alternatively you can get a "formation company" to do all the paperwork for you. However, they all charge a fee for something that's simple to do yourself.

For example, Company Formations 24.7 charges £53.99 to register the company for you, and send you the certificate of incorporation and an electronic copy of the memorandum and articles of association. Others, such as Companies Made Simple, offer a range of options, from basic company set-ups to packages, including services such as credit checks on other firms.

Are these formation companies worth the cash? In most cases, probably not. You can do everything they offer cheaper or free by following advice on Business Link or elsewhere on the web.

Occasionally they might offer something worthwhile, but make sure you shop around and get the best deal you can.

Case study

Lizzy Daly runs online shop Shabby Chic Originals, which started trading in November from a base in south-west London. It specialises in "gifts, treats and essentials for the home in a shabby chic style" – from spotty teapots to flowery cushions.

She says: "Having started my business on a shoestring, being a sole trader was the perfect option. It cost nothing with the exception of a phone call to HM Revenue & Customs to register as self-employed." However, she adds that it made a big difference to have her husband's help in getting the business off the ground.

After studying business and finance at university, she worked in events, marketing and communications for several years. When the recession hit, the company she was with couldn't afford to keep her on, so she left in early 2010 and worked as a temp for a few months while she developed her business concept.

For the moment, she is still a sole trader, though the plan is to become a limited company early next year. "Our team is growing, with warehouse staff and Heather, my new helper, who is invaluable," Daly says.

• Next week,part 2 of our series: Business bank accounts: do I need one and how do I pick the right one? What about an accountant?